Applying Lessons Learned from Previous Construction Slowdowns

By Colin Reid | August 04, 2008
One of the top mediators in the country used to start his mediations by saying, "If I do my job, everyone will leave here equally unhappy." While this always drew a laugh, there was a truth at the heart of the joke: the secret to surviving difficult situations is often to adjust expectations from what you would like to what you can actually live with. Companies in the ethanol industry should be pondering this truism right now.

It's no secret these are trying times from the industry boom that began in 2006 with President George W. Bush and others touting American-produced ethanol as a way to independence from foreign oil—a plentiful, renewable fuel that could drive us well into the 21st century.

Fast forward two years, and things have quickly changed for those building and supplying new plants. Companies whose balance sheets depend on the success of new ethanol plants are facing a significant—albeit expected—slowdown in construction projects.

However, all is clearly not lost. Ethanol production will not stop, and most companies have found ways to continue profitably running traditional corn-fed ethanol plants. Even so, many producers feel the future is in cellulosic-based feedstocks.

Fortunately, many owners and developers who answered the call to make ethanol the fuel of the future had the foresight to purchase larger tracts of land than were absolutely necessary for their corn-fed plants. Thus, in the long run, many of the companies currently facing economic difficulties may be able to retrofit the front end of their plants to allow for commercial-scale cellulosic or sugar-based ethanol production. Meanwhile, everyone who has been involved in the ethanol plant development industry for the past few years needs to figure out how to stay strong until that build-out period arrives.

Lessons from the Power Industry
Those caught up in the current difficulties can take comfort from the experience of plant owners, contractors, engineers and suppliers in the power plant construction industry in the late 1990s and early 2000s. Remember when Vice President Dick Cheney said in 2001 that we'd need a new power plant to come on line every week for the next 20 years to meet vastly increasing power demands?

A lot of people had the same view, resulting in an unprecedented construction boom, which was followed by increases in natural gas prices, problems with distribution and storage of gas and power, and revelations that Enron Corp. and others had manipulated supply to create the illusion that demand vastly exceeded supply. Plants were mothballed in mid-construction, completed plants sat rusting, and the scramble was on just to stay alive.

The good news is that many of these players in the gas-turbine power plant industry survived and are now doing quite well. How was it done? The answers are as varied as the companies involved in the ethanol industry, but there are some common themes.

Owners' Concerns, Cash Crunches
For owners who have cash coming in from other sources, the ethanol crunch may be creating temporary cash flow problems that can be dealt with by negotiating extended payment terms with creditors, including contractors, with appropriate security. This technique was used successfully during the power bust by a number of power plant owners that had lucrative contracts, deals or ventures, but were in a temporary crunch due to the cost of developing new power plants that were producing little or no revenue.

Almost all ethanol plant construction contracts contain terms allowing the owner to suspend work or terminate the contract for convenience. Proper use of these clauses may allow
the owner to stop incurring costs that it does not currently have the means to pay. However, these clauses should be used with caution, since they will usually result in higher project completion costs.

Ability to Complete Plants
If a project is incomplete and there is concern about the contractor's ability to complete the work, there may be several avenues open for consideration. Of course, if the contractor posted bonds, letters of credit or other security, look to those means to ensure performance. A word of caution in dealing with bonds—strictly follow all requirements and procedures stated in the bond. Failure to follow the bond to the letter can result in the loss of all rights under it.

Even if there is no security, the law of many states permits a "request for adequate assurances" even if no such right is stated in the contract with the contractor. If the contractor does not respond with reasonable assurances of its ability to complete the work, the owner may have a right to declare the contractor in default. This doctrine is discussed in more detail below.

For some owners and developers, bankruptcy is inevitable—the economics just don't work. In extreme cases, bankruptcy may take the form of liquidation, or it may take the form of a Chapter 11 reorganization that allows the debtor some breathing room from claims by creditors, and may allow the debtor to reduce or shed some bad debts while retaining profitable operations and relationships.



Contractor, Supplier Concerns
If a project is incomplete, many contracts (such as the American Institute of Architects or AIA forms) give contractors the right to request that the owner demonstrate adequate evidence of the owner's continuing ability to pay for construction. This right exists in many states even if it isn't stated in the contract. Called a request for adequate assurance, it was created for situations such as those affecting some in the ethanol market.

If a contractor has reason to believe that the owner won't be able to pay for the work when payment is due, perhaps a large retainage payment at the end of the job, the contractor doesn't have to keep working and running up costs just because the owner hasn't yet breached the contract by failing to pay. Instead, a letter can be sent stating the reasons for concern and requesting reasonable assurances of the owner's continuing ability to pay. If the owner fails to provide such evidence within a reasonable time period, the contractor or supplier can then treat that as a breach and stop work. This allows them to avoid incurring additional costs that may never be reimbursed. This approach enables cost savings, but should be exercised with caution and advice from a knowledgeable attorney.

If the owner is already late in making payments, the contractor may have a right to suspend work to avoid additional costs. The contractor may also have the right to notify the project lender of non-payment and require the lender to set aside loan funds for unpaid invoices. Again, caution is required and counsel should be consulted before acting.

Payment for Completed Work
A mechanic's lien rights exist in all states. It's important to determine whether the lien trumps the lender's mortgage. If not, the lender's first position mortgage may render the lien worthless.

In some cases, it may not be clear who has first position, which opens the door to negotiations. One particular value of the mechanic's lien is that it often creates coveted secured creditor status if the owner goes bankrupt.

Also, if the project has been finished with undisbursed construction loan funds, contractors, subcontractors and suppliers may have rights to a portion of these funds. Access to these funds may exist even if the owner files bankruptcy because such funds often are not treated as property of the bankruptcy estate.

Subcontractors and suppliers, who are below the design/build contractor or prime contractor in the contracting chain, may have other sources of recovery. Unless the subcontract includes an enforceable pay if paid clause, subcontractors should be able to collect payment for their work from the prime contractor even if the owner is insolvent. Also, there may be a payment bond, which allows recovery if neither the owner nor the contractor can pay.

The Best Tools: Communication, Realistic Expectations
All of the tools highlighted above were used by victims of the power bust to stay afloat and even remain profitable. Many more tools are available, but probably none is better than simple communication. Communication does not solve all problems. Sometimes there is simply no money and nothing will make it appear. However, if the parties become secretive and adversarial when trouble hits, there is no chance the parties will be able to come up with creative solutions that everyone—owner, lender, engineer, supplier and subcontractor—can live with.

Having represented and negotiated with numerous companies during both the gas-turbine bust and the current ethanol plant construction situation, it's apparent that solutions can best be reached on many projects if everyone is open and honest about the problems, and everyone is communicating and willing to compromise. You may not walk away happy, but at least you can walk away with your business intact.

Colin Reid is a member of the Construction Industry Practice Group at Sherman & Howard LLC, a Denver-based national law firm. Reach him at creid@shermanhoward.com or (303) 299-8230.